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Managing sales and use tax compliance and administration with self-audits and managed compliance agreements.

State tax administrators and corporate America face the same challenge: how to do more with limited resources. Sales and use tax compliance and administration are prime examples of this challenge. In general, state tax administrators target their limited resources toward major taxpayers to get the highest return on the audit dollar. As a result, administrators expend significant resources auditing compliant taxpayers, missing the opportunity to identify nonfilers and educate other taxpayers about their tax compliance requirements. To further complicate the issue, a taxpayer's professional staff, who may not be tax savvy (such as purchasing and operations personnel), continually make important decisions about the taxability of many types of purchases, creating the potential for overpayment of taxes as well as understatement of use tax liabilities.

State tax administrators and taxpayers increasingly rely on managed self-audits and managed compliance agreements to streamline sales and use tax compliance and administrative functions. These programs ensure that states collect no more or no less than they are due, and that taxpayers pay no more or no less than they owe. Tax administrators benefit from them by being able to efficiently reallocate resources, reduce audit costs by cutting travel costs and customize taxpayer education. Administrators also enjoy greater assurance that use tax is being accurately reported and taxpayers are being uniformly treated. Self-audits and managed compliance agreements also give administrators the opportunity to work in partnership with taxpayers.

Taxpayers enjoy reduced disruption of day-to-day operations, an ability to schedule detail review work during slow periods, better awareness of sales and use tax laws, better understanding of internal control strengths and weaknesses, simplified reporting procedures, reduced errors and reduced assessments (as a result of errors and understatements), as well as an opportunity to identify areas of overpayment and of potential refund. Both parties benefit from reduced litigation costs, with fewer audits subject to administrative appeals.

Tools to Manage Sales and Use Tax Compliance

A managed self-audit is an agreement between a tax administrator and a taxpayer that allows the taxpayer to perform a physical audit using procedures written by (or in conjunction with) the tax administrator and agreed to by the taxpayer. In general, agreements specify periods to be covered, accounts to be reviewed, sampling techniques to be used and time period within which an audit review must be finalized and a tax liability calculated. The administrator reserves the right to review the taxpayer's findings and adjust the results. A formal assessment may be issued at the close of an audit, or a taxpayer may be allowed to make a voluntary payment in an amount equal to the taxes and interest due. Most states abate penalties on outstanding liabilities; however, a few states offer an additional incentive by reducing interest on outstanding liabilities. Agreements can be tailored to meet the needs of both parties (e.g., determining how overpayments identified during a review will be handled).

A managed compliance agreement or effective rate agreement is a written agreement, generally entered into following the completion of an audit. It requires a taxpayer to self-assess a use tax liability for a specified time period, using an agreed-on effective rate. The agreement period may last anywhere from one to three years, and may be renewed if both parties agree to do so.

States Adopt Managed Self-Audit Programs

Approximately 30 states have some form of managed compliance agreement procedure in place or are in the process of implementing a similar type of program.


In 1993, Ohio was the first state to formally adopt a managed self-audit program. Under Ohio's program, taxpayers perform their own detail work according to the terms of their agreements with the Ohio Department of Revenue. The program was originally designed for small- to mid-sized taxpayers, in market segments too costly to audit on a consistent basis; it has expanded to include major companies with established audit histories and few complex issues. The department estimates that approximately 40% of all sales and use audits are managed self-audits.

In general, Ohio's auditors determine if a taxpayer is a good candidate for the self-audit program by reviewing the taxpayer's chart of accounts, depreciation schedules, purchase invoices, tax returns and reporting procedures. In addition, auditors must evaluate the taxpayer's ability and willingness to understand and deal with tax issues.

Since Ohio introduced its program, a number of states have followed suit. Some of these, like the ones implemented in California, Connecticut and Texas, were adopted as a result of formal legislation. Others are more akin to policies adopted by state revenue departments.


California enacted legislation authorizing the use of a managed self-audit program in 1998. By law, the State Board of Equalization (SBE) can enter into managed self-audit agreements with taxpayers until Jan. 1, 2001. A taxpayer's participation in the program is voluntary and, to the extent the taxpayer agrees to the program, 50% of the interest and all penalties are waived. To be eligible to participate, a taxpayer must (1) have not received written notice requiring tax prepayments, (2) have a business with few or no statutory exemptions and only a few clearly defined tax issues, (3) agree to participate in the program and (4) have the resources to comply with the SBE's instructions. The SBE must identify the audit period, the types of transactions covered, the procedures to follow to determine unreported liability, the types of records to review, the manner in which the types of transactions are to be scheduled for review, the deadline for completing the audit, and the time period for payment of liability and interest. If a taxpayer does not satisfy the requirements of the managed self-audit, the SBE may proceed to examine the taxpayer's records. Taxpayer participation in the managed self-audit program does not limit the SBE's authority to otherwise audit a taxpayer.


In June 1999, the Connecticut legislature authorized the use of managed self-audit agreements as part of its broader managed compliance program. The legislation authorizes the Department of Revenue Services to enter into managed self-audit agreements and managed compliance agreements. The self-audit process begins when a taxpayer submits an application to the department. (Taxpayers under audit may submit an application directly to an examiner.) In general, the application requests information about the quality and availability of an applicant's source documents (e.g., chart of accounts, Federal and state returns, sales and purchase journals), compliance history, staffing and other resources. Based on the quality of responses, the department will consider whether an applicant is a candidate for a managed self-audit. Eligibility generally depends on a taxpayer's compliance history, the quality of its internal controls and anticipated time savings.


Effective Oct. 1, 1999,Texas adopted a managed self-audit program. Texas's program authorizes the comptroller and taxpayer to enter into an agreement that allows a taxpayer to conduct a managed self-audit to determine its sales and use tax liability for specified transactions occurring during a specific time period. Penalties are abated and interest may be waived by the comptroller's office when it verifies audit results. Penalties and interest, however, are imposed if there is fraud or willful tax evasion, or a taxpayer does not remit the tax actually due. In determining whether to authorize a taxpayer to conduct a managed self-audit, the comptroller may consider (1) a taxpayer's history of tax compliance, (2) the amount of time and resources a taxpayer has available to dedicate to an audit, (3) the extent and availability of a taxpayer's records and (4) a taxpayer's ability to pay any expected liability.


Virginia's managed self-audit program originally applied only to companies that use a corporate purchasing card use tax accrual system. Programs were tailored to the specific taxpayer and approved by the Department of Taxation prior to implementation. The program has been expanded to other types of taxpayers.

Under Virginia's program, an auditor generally conducts a detailed audit of the first year of a three-year audit period. Taxpayers are responsible for auditing the remaining two years and reviewing the results with a state auditor.


The Maine Bureau of Taxation introduced the managed audit approach based on the success of its Cooperative Compliance Review (CCR). Maine's CCR audit begins with discussion between a taxpayer and an auditor, with cooperation established from the first audit contact. The taxpayer and auditor determine areas of agreement and then target any areas of concern; a schedule of work is agreed on. The emphasis is on auditing existing computer records, with the state auditor providing regular reviews of the audit's progress.


Kansas is considering a legislative proposal authorizing the Director of Taxation to enter into managed audit agreements with certain taxpayers. The legislation (SB 410), approved by the Senate, will reduce the interest rate on delinquent sales and use tax liabilities by 50%.

Taxpayers interested in participating in a managed self-audit should consider working with an adviser familiar with the process, who can help explain the process, prepare for meetings with an auditor and perform the detail work. In addition, taxpayers need to be sure they understand their responsibilities under an agreement and have the resources necessary to complete the detail work within the deadline. Taxpayers concerned about the time commitment required in a self-audit have enlisted the assistance of outside consultants knowledgeable in state taxes.

It is advisable to contact an administrator prior to receipt of an audit notice, to discuss the possibility of a managed self-audit. Some state administrators may be more willing to agree to the process before department resources are allocated. In addition, some states may reduce the interest owed on any outstanding liability if a taxpayer makes the first move. Most of all, acting in good faith when setting the scope of the review and performing the detail work deters state administrators from rightfully assessing penalties and interest. Further, not acting in good faith may preclude a taxpayer from future managed self-audits or managed compliance agreements.

Managed Compliance Agreements

These agreements streamline the sales and use tax compliance and administrative function on a prospective basis. As with managed self-audits, a state's ability to enter into a managed compliance agreement may result from legislation or from administrative policy, based on the implicit authority granted to administrative agencies under the general sales and use tax statutes.

As discussed, a managed compliance agreement is a formal agreement between a taxpayer and a tax administrator that establishes a simplified procedure for reporting use tax liability. Agreements generally address issues such as the effective tax rate, types of purchases that agreements cover, the procedures to follow to ensure compliance, and a taxpayer's record retention requirements. When appropriate, agreements also address local taxes. In general, agreements apply to expense accounts involving a high volume of transactions with relatively small dollar amounts. Unusual and nonrecurring transactions (e.g., capital purchases) are generally excluded from an agreement. For example, in Connecticut large volume purchases of taxable goods and services that a business makes for its own use on an ongoing basis will generally be included in a managed compliance agreement. In addition, capital asset purchases may be included. Purchases excluded from an agreement include the following:

* Tangible personal property incorporated into real property new construction;

* Resale and inventory purchases;

* Utility services;

* Telecommunications services;

* Meals and lodging;

* Motor vehicles, vessels, aircraft and snowmobiles; and

* Items the taxability of which is in dispute.

Most agreements assume that past purchasing trends will remain relatively constant in the future. Accordingly, a model can be developed to estimate the amount of taxable purchases made during a contract period. Most often, a rate is based on the error factor of the most recent audit or refund period; however, the rate may be modified based on statistical or judgment sampling. For example, a rate may take into consideration internal control improvements established as a result of a managed self-audit.

A managed compliance agreement streamlines the audit process for state tax administrators. Because the rate is agreed to up-front, a state gains greater assurance that tax will be more accurately reported. Accordingly, the amount of audit work required at the end of a managed compliance agreement period is significantly reduced. In addition, formalizing the terms of an agreement in writing protects a taxpayer from the risk that a future state tax administrator will not honor an informal agreement made with a former administrator. Conversely, a state administrator also has better assurance that taxes will be accurately paid if there is a change in a taxpayer's tax department personnel.

Managed compliance agreements increase tax compliance accuracy. In general, they benefit taxpayers with a history of large overpayments or underpayments or both, such as:

* Manufacturers;

* Taxpayers with significant purchasing power, capital and/or an extensive distribution system;

* Taxpayers making significant purchases of materials, equipment, repairs and upgrades;

* Taxpayers with annual sales and use tax payments of greater than $200,000 per state; or

* Taxpayers with sales and use tax assessments of greater than $200,000 per state.

Managed compliance agreements work best in states with direct pay permits. Under a direct pay permit, a taxpayer purchases most goods and services tax-free and self-assesses use tax on taxable goods and services. Payment is made directly to the state when the goods are put to use rather than remitted to a vendor up-front. A direct pay permit simplifies the reporting procedure and ensures that a taxpayer will not pay tax more than once (i.e., once to the vendor and once to the state).

A managed compliance agreement is individualized for each taxpayer. As noted, the agreement covers the effective tax rate, types of purchases and period of the agreement. An agreement also provides a method to reconcile the effective rate with a taxpayer's actual use tax liability. Most agreements provide for a review of a taxpayer's records at the end of the agreement period.

The verification process involves reviewing procedures and sampling transactions that occurred during the term of the agreement, to determine if the amount of use tax reported accurately reflects a taxpayer's actual liability. It does not involve a determination of a taxpayer's actual liability on a transaction-by-transaction basis, as occurs in some field audits. A review may be conducted by a taxpayer or by a state tax administrator.

Situations that lead to a tax over- or underpayment during the course of a managed compliance agreement may be due to change in exemptions, resulting from new legislation, clarification of a specific statutory provision based on a court ruling, new or improved cost containment efforts, changes in financial accounting systems or a change in a taxpayer's suppliers or operations. Overall, an agreement will provide that, if there are significant changes in the factors affecting an agreement (e.g., a merger, acquisition or spin-off), the agreement must be modified or terminated. For example, Connecticut's managed compliance agreement program provides that an agreement may be terminated if any of the following events result in a material change to a taxpayer's business operations:

* Significant changes involving business activities outsourced or transferred;

* Significant start-up or closing of facilities;

* Merger or acquisition;

* Adoption of cost containment programs; or

* Significant financial or accounting changes.

An agreement usually provides that it may be terminated by mutual consent of the parties. In addition, states reserve the right to terminate an agreement if a taxpayer fails to comply with the agreement's terms or for fraud.

Some states lack the authority to compromise tax liabilities. These states are known as "reconciliation states." Accordingly, these states' agreements allow them to issue assessments, or allow taxpayers to claim a refund, if the use tax reported over the agreement period does not reflect a taxpayer's actual liability. Provided a taxpayer has complied with the terms of an agreement, penalties are generally waived. These types of agreements may create a problem for some taxpayers because they have a negative effect on the cost of doing business (e.g., the measurement on which a plant manager or department chief is paid).

Some state agreements allow an administrator and taxpayer to agree to waive under- or overpayments, provided the difference falls within an agreed-on range. A handful of states (i.e., nonreconciliation states) prohibit the assessment of tax or the granting of a refund, and merely roll the difference into the effective rate used during the next agreement period.

Taxpayers need to know about their rights under a managed compliance agreement. Before entering into such an agreement, taxpayers should note whether they retain all rights generally available to other taxpayers during the agreement's term. For example, Connecticut's statute provides that its Taxpayer Bill of Rights applies to all taxpayers, including those under a managed compliance agreement. Specifically, taxpayers with a managed compliance agreement have rights to informal audit conferences, oral hearings to petition for reassessment and the court system. Therefore, taxpayers can protest or appeal disputes about the taxability of goods or services that arise during a true-up or verification process.

Certain states (such as Missouri, Minnesota and Wisconsin) have begun restricting the use of managed compliance agreements in an effort to determine if they really work before signing up any more taxpayers. However, taxpayers should not be discouraged from approaching administrators in these or other states if they think they would benefit from a managed compliance agreement.

Taxpayers considering entering into managed compliance agreements are well advised to seek the assistance of a seasoned tax adviser prior to entering into any agreement. A well-structured agreement requires a taxpayer and tax administrator to devote time up-front, analyzing the various areas to be covered. In certain situations, an agreement may require a taxpayer to change some of its internal accounting procedures. An experienced adviser can address all appropriate areas at the outset and help in the development and implementation of systems for a smooth transition for all parties.


Managed self-audits and managed compliance agreements can be effective tools for taxpayers and administrators in today's business environment. These tools generally provide a win-win solution for both taxpayers and tax administrators. However, taxpayers should exercise caution before signing any agreement, to ensure that they have a clear understanding of their rights and responsibilities. A tax adviser knowledgeable in managed self-audits and managed compliance agreements should be able to provide the necessary guidance in determining if they would benefit a taxpayer.

Author's note: This article is based on Nakamura, "Managed Audits and Effective Rate Agreements: Cooperation Benefits All," 5 Multistate Tax Report 429 (October 1998).


Karen J. Boucher, CPA Arthur Andersen LLP Milwaukee, WI

Karen Nakamura, CPA PricewaterhouseCoopers LLP Washington, DC

Ms. Boucher chairs the AICPA Tax Division's State & Local Taxation Technical Resource Panel. Ms. Nakamura is a member of the State Tax Checklists Task Force.

If you would like additional information about this article, contact Ms. Nakamura at (202) 414-1327 or
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Author:Nakamura, Karen
Publication:The Tax Adviser
Geographic Code:0JSTA
Date:Jun 1, 2000
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